Spreads and Investment Costs
Novices considering currency trading will read that Forex brokers charge no commissions and cheer. But don’t be fooled. Whether anything in life is truly free may be up for debate, but one thing is certain: nothing in investing is.
Forex market makers and brokers make money from something called ‘the spread’. It’s important you understand how it works.
Suppose a trader is dealing directly with a market maker. A market maker is an individual or company that directly offers a currency pair trade, as distinguished from a broker who acts as an intermediary. The bid price is that which the market maker offers to BUY the base currency from the trader. The ask price is that which the market maker requires in order to SELL the base currency in exchange for the quote currency.
For example
EUR/USD 1.1900/05 means
If you buy 1 EUR you will pay 1.1905 USD
If you sell 1 EUR you will receive 1.1900 USD
The difference between those two prices is called the SPREAD and it is how market makers (and, indirectly, Forex brokers) make a profit, in stead of charging commissions. In practice, for every seller there must be a buyer for any trade to take place. The broker, acting as an intermediary – unless he or she is also a market maker buying and selling for his or her own account – locates a trading partner.
If you are willing to sell euros at the exchange rate of $1.1900 the broker locates someone willing to buy them at $1.1905. The broker pockets the difference, in stead of receiving an explicit commission.
How does this affect you, the Forex trader? You are paying for the spread, in essence.
Suppose you were to accept the trade and sell euros for dollars. The bid price will apply so you receive 1.1900 dollars for every euro sold. Now suppose you wanted to immediately buy those euros back from your broker. The ask price will apply so you would pay a rate of 1.1905 dollars for every euro acquired. That difference, the spread, is measured in points or pips, in this case 5 pips.
That five point difference would result in an immediate loss to you, even though the exchange rate hasn’t changed by a single pip. You sold euros for 5 pips less ($1.1900) than you bought them for ($1.1905).
Calculated in terms of dollars rather than points, you would lose $5,000 on an immediate trade of 100 lots. $11,905,000 – $11,900,000 = $5,000. At 1/250th leverage, however, this equates to an actual ‘commission’ cost of $5,000/250 = $20.
It’s perfectly legal and ethical. It’s simply the cost (to you) of trading in foreign currency.
As a result of the spread, which accompanies every quote, traders must wait for the market to move by at least that amount just to break even. To profit, the exchange rate must move by more than the spread. Of course, while you wait, the exchange rate can move in either direction and may result in an even greater loss if you liquidate your position.
In our example, you sold euros at 1.1900 and will have to see at least a 6 pip change in ask price (from 1.1905 to 1.1899) before you can buy euros at a profit. Every currency pair price – the exchange rate – moves, by definition and convention, a minimum of 1 pip. You will never see a 1.5 pip change, for example. This minimum is a one point change in the last digit in the price quote.
Of course, actual trading is not so simple. That needn’t be bad, though. That can work for you. Brokers or market makers offer different amounts and types of spread to different customers at different times.
Spreads may, and often are, narrower for those who have a 100K account and larger for those with a mini account. You put more money into the game and you get a better deal. That’s reasonable and normal.
Spreads for a mini account may be as high as 10 to 15 pips, and as low as 5 pips or less for a 100K account. Large banks and institutional traders are typically the only ones to receive ultra-low spreads.
Also, many brokers differ in the terms under which they’ll offer variable versus fixed spreads. For example, a broker might offer a variable, and decreasing, spread as the notional amount of the trade increases.
As an example, you offer to buy 10 standard lots of euros (10 x 100,000 euros x 1.1905 $/euro = $1,190,500) and the spread is, say, 3 pips. If the deal were only for 1 standard lot (100,000 units) the spread might be 5 pips.
Note that because Forex trading is highly leveraged a trader may only have to input 1/250th of the actual amount of dollars. Even that low fraction still amounts to an investment of $4,762 ($1,190,500/250) for 10 standard lots. Though high, that amount is within the reach of many non-professional traders.
Spreads can differ due to a dozen different circumstances. Just as with bonds, mortgage lending and every other form of investing today, the variations are many. Spreads will differ from broker to broker and from trade to trade. They can depend (as we’ve seen) on the amount traded, the established relationship between broker and client, or recent volatility, or current liquidity… The list is endless.
As a result of this, it pays the trader to do some homework and shop around for brokers that offer their clients the best spreads, on average. But beware – cheaper is not always better. Fixed spreads are typically slightly higher than variable, but offer the insurance of locking in a known cost.
It does little good to get great (super-small) spreads if your broker’s execution times are typically bad or if trades are frequently rejected. You want trades made quickly so they can be made as close as possible to the up-to-the-minute price you saw on your screen. You also want a broker who will be honest and ethical and not employ any of the many tricks of the trade for increasing their profits at your expense.
If you make the effort, you will find a broker or market maker who offers honest deals at reasonable spreads. Despite the huge volume of Forex trading (in the neighborhood of a few trillions daily worldwide among thousands of banks), it is still in some ways a small world. Word gets around and a bad reputation can ruin a broker.
Make sure you read the fine print and execute enough demo and small dollar volume trades to get used to Forex trading and how spreads affect your profits and losses. Forex trading is much more complex, volatile and fast-paced than even typical day trading in stocks. An educated investor will suffer fewer avoidable losses.
Choosing a Forex Broker
Choosing a good Forex broker can be as complicated as Forex trading itself. For that reason, investors should do their homework as diligently as they would for a trade. Here are some tips to keep in mind to make your research and choice easier.
In the U.S., any worthwhile Forex broker will be registered as a Futures Commercial Merchant (FCM) with the CFTC (Commodities Futures Trading Commission). Finding one doesn’t end the need for research, it’s just the bare minimum you should require.
Since Forex trades are highly leveraged (in effect, the broker ‘lends’ an investor up to 99% of the money required to make a trade), the broker you select should be associated with a firm with deep pockets.
Forex accounts are not FDIC (Federal Deposit Insurance Corporation) insured, so you can not expect the U.S. government, or anyone else, to bail out the brokerage firm or reimburse you if the market turns sharply downward. Large institutions, with ample capital to withstand downturns in the market, and rapid drains on their deposits if clients withdraw en masse, are crucial to your financial peace of mind.
Beyond those rock bottom basics there are many options.
Since the Forex markets trade 24 hours per day all around the world, you may want to trade after normal business hours in your home country. Whether your broker resides in the same country (usually, for language and legal reasons) or not, you want one who will pick up the phone when you call.
Forex trading has moved into the Internet age, but it is still very much a phone-based business. Getting a broker on the phone at any time of the day or night can mean the difference between profit and loss. Sometimes, big profit or loss.
Since Forex brokers don’t work off standard commissions the way stock or bond brokers do, you need to research the firm’s spreads. Forex trading is always done in currency pairs. A spread is the difference between the bid and ask price – what the broker pays to buy versus the amount they sell a currency for.
Some brokers will offer fixed spreads on all trades, which has the advantage of predictability. It’s a kind of fixed ‘commission’. But that may or may not suit your trading style or your budget, since they tend to be larger than variable spreads.
Any broker will offer a standard account to a qualified client. Typically you have to fill out an application form that states you have adequate capital and understand the risks involved in Forex trading. Standard accounts trade currency in standard lots of 100,000 units. You can’t buy 100 euros for $150, you have to buy 100,000 euros.
Since that’s a very large investment for the average trader, brokers offer leverage. Professional traders use leverage as well, of course. In other words you put in, say 1% of the total, the broker puts up the rest. That has huge profit (or loss) potential, but it entails significant risk. So be aware of a broker’s margin call policy.
Many brokers today will offer some form of ‘mini’ account. Instead of trading in standard lots, they trade in smaller units, such as 10,000. This lowers the investment required from, say $2,500 to only $250. Most clients can easily meet that minimum.
But that lower leverage requirement limits the potential for profits. That may or may not suit your investment needs. Only you can decide.
You’ll want a broker with software that provides you with the research and other trading tools you will need to be effective in Forex trading. Forex investing is much more complex and volatile than even stock or bond trading, which is already not simple when done well.
Be sure to use the trial accounts offered and make several ‘fake’ trades in order to test out the software and research available. You need real-time prices – Forex moves very fast – and lots of technical and fundamental analysis information at your fingertips.
There are websites and forums where specific brokers are discussed, but take what’s said there with a grain of salt. Just as with complaints about vendors on eBay or Amazon and other large Internet trading arenas, a few bad remarks shouldn’t ruin the reputation of honorable brokers.
Beyond all that, the factors become a little more difficult to judge. Above everything, you want to feel you trust the person on the other end of the line. They are not there to be your friend or listen to personal complaints or trade tips. But you should get the sense that they are competent, professional and ethical.
Take your time to research. After all, your decision will affect ALL your trades.
Facebook